Explanation:
The Liquidity Preference Theory is the correct answer. This theory suggests that investors prefer to invest their funds for shorter periods, while borrowers are more inclined to borrow at long-term fixed rates. The theory also asserts that forward rates exceed future spot rates, providing an empirical explanation for the upward slope of the yield curve. This theory is based on the premise that investors require a premium, or a higher return, for holding long-term securities because they are considered riskier. The risk arises from the uncertainty about future interest rates and inflation. Therefore, to compensate for this risk, long-term rates are generally higher than short-term rates, resulting in an upward-sloping yield curve.\n\nChoice A is incorrect. The Expectation theory suggests that the yields on long-term bonds are an average of expected future short-term rates. It does not account for the preference of investors to invest their funds for shorter periods or borrowers' inclination to borrow at long-term fixed rates.
Q.664 Transactions worth billions of dollars depend on the shape of the zero rate curve. The shape of the zero curve has gained the attention of economists, mathematicians, and investors. Many theories exist that present their perspective about the shape of the zero curve. One of those theories suggests that investors are likely to invest their funds for a shorter period while borrowers are more willing to borrow the funds at long-term fixed rates. The theory also concludes that the forward rates are greater than the future spot rates, which justifies the empirical result that the yield curve tends to be upward sloping. Which of the following theories provides the above-mentioned conclusion?
A
Expectation theory
B
Market segmentation theory
C
Liquidity preference theory
D
None of the above
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